Source: OfTwoMinds blog, by Charles Hugh Smith
There are multiple sources of friction in the Perpetual Motion Money Machine.
We’ve been playing two games to mask insolvency: one is to pay the costs of rampant debt today by borrowing even more from future earnings, and the second is to create wealth out of thin air via asset bubbles.
The two games are connected: asset bubbles require leverage and credit. Prices for homes, stocks, bonds, bat guano futures, etc. can only be pushed to the stratosphere if buyers have access to credit and can borrow to buy more of the bubbling assets.
If credit dries up, asset bubbles pop: no expansion of debt, no asset bubble.
The problem with these games is the debt-asset bubbles don’t actually expand the collateral (real-world productive value) supporting all the debt. Collateral can be a physical asset like a house, but it can also be the ability to earn money to service debt.
Credit card debt, student loan debt, corporate debt, sovereign debt–all these loans are backed not by physical assets but by the ability to service the debt: earnings or tax revenues.
If a company earns $1 million annually, what’s its stock worth? Whether the market values the company at $1 million or $1 billion, the company’s earnings remain the same.
If a government collects $1 trillion in tax revenues, whether it borrows $1 trillion or $100 trillion, the tax revenues remain the same.
If the collateral supporting the debt doesn’t expand with the debt, the borrower’s ability to service debt becomes increasingly fragile. Consider a household that earns $100,000 annually. If it has $100,000 in debt to service, that is a 1-to-1 ratio of earnings and debt. What happens to the risk of default if the household borrows $1 million? If earnings remain the same, the risk of default rises, as the household has to devote an enormous percentage of its income to debt service. Any reduction in income will trigger default of the $1 million in debt.
If a household earns $100,000 annually, how much can it borrow? The answer depends on the terms of the debt: the rate of interest and the percentage of principal that must be repaid monthly.
If the interest rate is 0% and the monthly payment is fixed at $1, the household can borrow billions of dollars. This is how the game is played: there is no upper limit on debt if the interest rate is effectively zero, or adjusted for inflation, less than zero.
Would you lend the household your savings, knowing you’ll never get any interest and the principal will never be repaid? Of course not. Nobody in a functioning market for capital would throw their hard-earned savings away on a debtor who can’t pay any interest or principal.
The only institutions that can play this game are central banks, which create money out of thin air at zero cost. As for risk–the way to manage defaults is to print more money.
But once again–printing money doesn’t create collateral or income needed to service debt. As I have explained, printing money is akin to adding a zero to currency. Every $1 bill is now a $10 bill. Are you ten times wealthier once the central bank adds a zero to every bill? No, because the $5 loaf of bread is re-set to $50.
The other problem with this game is interest keeps ticking higher while earnings remain flat. Even at very low rates of interest, interest payments keep rising. This is not an issue if income rises along with interest payments, but if income is flat, paying higher interest costs eventually pushes the borrower into default.
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